Stock Prices:
Read on only if you're willing to throw out what they teach you in business school…
Namely, that stock prices are simply the market's representation of the discounted present value of a future stream of cash flows. I take issue with that and would instead tell you that stocks have emotions.
What? Stocks have emotions?
That's crazy you say. Maybe… but people don't listen to me who want the conventional "blah blah blah" that comes from textbooks and an MBA. My guidance comes from real life. And yes, I say stocks have emotions. It's really not that complicated or controversial when you think it through.
That's because stocks are purchased by fund managers who, despite what everyone says about them, are human beings with emotions. And those fund managers (and their analysts) do everything they can to not lose their jobs, because these are good, high-paying jobs with lots of perks. And so therefore… the decisions to buy and sell stocks, while rooted in that formula of discounting the present value of future cash flow streams, is primarily rooted in the emotion of feeling safe. Sure, stock market participants are of course in the business of taking risk, so this isn't about feeling completely safe… but the safer someone feels owning a particular stock, all else equal, the more of it they're going to want to own.
Why is that? Well… when companies miss numbers, their stocks tend to get crushed. And when an investor owns a stock that gets crushed, they generally start to worry they're going to get fired . If it happens a few times in a row, they can count on that happening. So… all else equal… investors prefer stocks where they don't have to worry about the company missing their numbers. It's really no different than keeping your hands away from the stove after you've been burned.
So how does this manifest in stock prices?
Well… companies that have volatile earnings reports… you know, the kinds of companies that tend to make a few quarters in a row and then miss a couple before getting on track again, will likely have lower multiples (all else equal) than those companies who are able to consistently beat-and-raise Street estimates. Think about the companies that "need to show a few quarters of consistent execution to restore investor confidence" vs. companies that hear nothing but "congrats on a great quarter again guys… nice to see out-year estimates coming up yet again." It's night and day for their multiples.
So what? Well the "so what" here is that this means the onus is upon public companies' IR departments and their investor relations consultants to properly manage Street numbers and to help the Street get comfortable that, no matter the situation, the company has constructed their guidance and the consensus estimates in a way that can make investors feel safe.
How do they do that if their earnings are cyclical or volatile?
It's tricky of course....and much harder than for a SaaS compounder that can see 12 quarters out and easily manage estimates. But it's also not impossible.
The solution is to over-communicate. If you crush numbers one quarter, don't just take a victory lap and focus on your positives. Instead, be humble and remind investors about the risk factors in your business. Go out of your way to try and quantify how much you "over-earned" beyond their normal trendline. How many companies crushed numbers in COVID only to blow up in late 2021 when the world opened up? Hindsight is of course 20-20, but what would I have told these companies when they were absolutely killing it during the height of COVID? I'd have told them to quantify how much extra growth they think they got due to COVID and to go out of their way to point out that this would therefore create difficult comps the following year. This would have the effect of keeping 2021/2022 numbers in check and....voila - making investors feel safe.
Make investors feel safe, and you'll be rewarded with a higher multiple. It's really that simple. Stocks have emotions!
